"Because they carry obligations to make future payments, external debt liabilities have the potential to create circumstances that render an economy vulnerable to solvency and liquidity problems. Moreover, as experience has shown, external vulnerability can have widespread economic costs, and not just for the initially affected economy. It is clear, therefore, that external debt needs to be measured and monitored." [see here the IMF guide on external debt]
Under this perspective, it will turn easy to realize that the most important variable to assess the financial health of a country is given by the current account balance (CA) [see, e.g., J.L. Stein here ].
In the introduction below on the meaning of the current account, we will see how it links some macroenomic variables which are at the base of the financial health of a country.
1. The Current Account Balance
The current account of balance of payments records the international trade in goods and services, and the income and current transfers [see below equation 1].
A negative balance (i.e., a current account deficit) indicates that a foreign country spends more than it earns from transactions with other economies and therefore is a net debtor to the rest of the world.
Overall, the current account sheds light on the economic position of a country compared to other countries, recording all transactions occurring between resident and non-resident units. Equation 1 summarizes the content of the current account:
1) CA = (X - M) + NIA
where (X - M) is the balance of trade or net exports, that is the difference between the value of the goods and services producted in the country (X) and the value of the demand of goods and services bought from abroad (M). NIA is the net income from abroad, that is the net flow of income and financial assets from abroad.
The net financial components of the account (i.e., direct investment, portfolio investment, financial derivatives, other investment, and official reserve assets) rather than the net incomes are expected to form the greater part of the NIA.
Negative values of NIA indicate net payments of interest and profits to foreign capital, that is, interest on external debt.
From another point of view, we can also consider the NIA as the complementary amount of income to be added to the Gross Domestic Income (GDP) to form the Gross National Income (GNI):
2) GNI = GDP + NIA
Let's now explicit GDP into equation 2, that is:
3) GNI = (C + I + X - M) + NIA
where C and I represent, respectively, the value of the domestic consumption and investment. Therefore, by recalling the equation 1:
4) GNI = C + I + CA → 5) CA = GNI - C - I = NS - I
Equation 5 shows that the current account balance is the quantity of the national savings (NS) which remains from the payment for the investment expenditures. If this difference is positive, then the surplus of NS may be invested in activities abroad through the international financial markets. Otherwise, if the national savings do not suffice to cover the investment expenditures (NS - I < 0), the country needs turn to external financing. In the former situation the current account balance marks a net external credit and in the latter a net external debt.
So, while in the equation 1 the current account balance reflects the net trade activity, in equation 5 we can see its financial counterpart, that is the net external position (NEP) (credit/debt).
6) CA = (X - M) + NIA = NS - I
The accumulation of the net external positions over the time produces the stock of external debt, ED, and, of course, a positive value of the sum yields the stock of external credit.
We obtain a further interpretation of the current account balance by introducing the public sector into the equation 5 and by decomposing the national savings so that NS can be seen as the sum of the private savings (PS) and the government (i.e., public) savings (GS). Hence we write
8) NS = PS + GS → 9) CA = NS - I = (PS - I) + GS
The quantity GS is the primary balance, that is the difference between the general government revenue (T) and the general government expenditure (G).
10) CA = (PS - I) + (T - G)
Equations 9-10 provide another relevant key point for supporting the role of the CA as the fundamental macroeconomic quantity. In fact, they allow to assess the contribution of both the private sector and the public sector to the formation of the current account balance.
2. Considerations
- Strictly speaking, the current account balance is the pivotal quantity that links the balance of trade to the stream of the net financial assets by triggering a loop like this: a net exporter country (X - M > 0) will take advantage from increased national income (see equation 3). This will improve the net external position (equation 5) which, correspondingly, raises the NIA and hence the GNI (equation 3).
- But a globalized economy behaves as a conservative system, therefore the existence of a net exporter country implies the existence of one (or more) net importer country. This obvious implication of symmetry is often forgotten by some common information network, politicians and analysts and someone seems to give a positive moral attribution to export and a negative attribution to import. Possibly, at the same time they also would greet enthusiastically the inflow of capitals from abroad. How to say, they worry with expenditures (direct cost of import) but they do not with debt (interests on the foreign liabilities).
- Along with a "global" level of equilibrium of the CA among the countries, we can also consider a tendency towards equilibrium in a longitudinal (i.e., time) scale of the CA within each country. In fact, in the middle-long run, it becames harder to sustain large CA, because at higher incomes will correspond higher consumption and investments expenditures (equation 4). Hence import will tend to increase and national savings to decrease. This "natural" balance needs increased levels of consumption and investment correspondingly to the increase of CA.
- In front of strong imbalance among the balance of payments of countries belonging to a (quasi-)homogeneous currency area, like the Euro-area, symmetrical mechanisms for managing (either by expanding or by restraining) the aggregate demand should be implemented by the pool of the countries of that area accordingly to the sign of their current account balance and to the amount of external debt (credit). Countries with large deficits in the balance of payments are asked to cut their expenditures and/or raise the taxation and/or restrain the domestic payroll in order to improve the balance of trade. These measures aim at producing a deflation effect by which the import of foreign goods and services is disadvantaged, while the export would be facilitated by the improvement of the competitiveness induced by lowered costs of production. Of course, this is a tough policy that involves social costs, e.g., in terms of unemplyoment, enderemployment, job underpayment. But, in order to get effective benefits from these measures, it is necessary that the countries of the same currency area with large positive surplus in the balance of payments should be willing to facilitate the importation by letting the general level of their domestic prices raise for a limited time.
- Otherwise, it seems unfair that a group of inherently heterogeneous countries share the same currency if the underlying purpose for holding that currency is inspired by mercantilism rather than to be addressed to reinforce some common ideals and interests of that area.
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